Risk Management

This Land Is Your Land

Changes afoot in lease accounting will have dramatic effects on retail and REIT balance sheets.
Alan RappeportJuly 1, 2007

Imagine a world in which AMB Property Corp., which owns more than 100 million square feet of real estate, appears to lose all of the property on its balance sheet overnight. Or where Walgreen Co., the giant drugstore chain, suddenly sees $26 billion in operating leases weighing down its ledger.

This through-the-looking-glass world is just two years away from becoming reality. The Financial Accounting Standards Board, along with the International Accounting Standards Board (IASB), is hard at work revising accounting rules that currently allow companies to keep most of what they lease off their balance sheets. For real estate firms and the companies that lease from them, the outcome will be, on paper, dramatic inversions in property ownership. “You won’t see a rental company anymore,” predicts Tom Olinger, CFO of AMB, a San Francisco–based real estate investment trust (REIT). “You’ll basically see a finance company.”

FASB is scuttling FAS 13, the 31-year-old standard that defines capital and operating leases and spells out their accounting treatment. Unlike capital leases, which are generally used to finance assets, operating leases need not be recorded on the balance sheet, and often appear only in the footnotes of company reports. FAS 13 set the bar for operating leases relatively low, requiring them to last less than three-quarters of a property’s economic life, with future payments adding up to less than 90 percent of its value. Even so, companies have long been accused of using creative measures to ensure that their leases qualify as operating leases.

Two years ago, the Securities and Exchange Commission estimated that 63 percent of public companies used operating leases, compared with 22 percent for capital leases. Aswath Damodaran, a finance professor at New York University’s Stern School of Business, estimates that capital leases now account for just 10 percent of all leases. The SEC, which called for lease accounting to be revised in the wake of Sarbanes-Oxley, estimates that $1.25 trillion of (undiscounted) future cash obligations resides off the books.

Ratings agency Standard and Poor’s notes that if operating leases were converted to capital leases, hundreds of billions of dollars in assets and obligations would instantly hit balance sheets — potentially rattling capital markets. According to a 2006 research note from investment bank Bear Stearns, the aggregate debt of nonfinancial S&P 500 companies would rise by 17 percent if all leases were capitalized.

Some sectors will really feel the pain. “The order of magnitude would be greatest for large retailers,” says Mindy Berman, managing director of Jones Lang LaSalle, a real estate services firm. According to an analysis by Bill Bosco, head of consultancy Leasing 101 and a member of the international working group for lease accounting, 13 of the 20 companies with the largest holdings of operating leases are retailers. Home-improvement stores, big-box retailers, and drugstores are high on Bosco’s list.

Given Walgreens’s total current assets of $9.7 billion, adding $26 billion in operating leases to the company’s balance sheet would throw its ratios seriously out of whack. The drugstore chain is reluctant to speculate on that prospect. “We’ll have to see what happens,” says Michael Polzin, a spokesman. “The information [on operating leases] is already in our annual report. Whatever the regulations are, we’ll follow.”

The New Approach

Proposals for the new regulations remain sketchy, but most are based conceptually on a document known as the G4+1 position paper. Composed by international regulators in 1999, the paper recommends that a lessee should recognize the asset and liability equal to the fair value of the rights and obligations of the lease, usually the present value of the minimum payments required. Thus, leased assets and liabilities would be treated as fixed assets and debt, while lessors would record receivables and residual interest as assets on their balance sheets. This conceptual approach would eliminate the distinction between capital and operating leases.

For companies that rent, moving leases to the balance sheet will inevitably raise questions, says Carleen Kohut, CFO of the National Retail Federation, a trade group. “What does this do to your bank covenants? How does this affect your gross margins?” Yet analysts, regulators, and CFOs agree that companies should not structure their businesses around accounting rules. “You try not to let accounting rules wag the economic dog,” says Jerry Gronfein, CFO of Ben Bridge Jeweler, a 79- store retail chain owned by Berkshire Hathaway. “Cash is still what matters.”

Still, some companies might try to wag the economics a bit. They could, for instance, reject leasing completely, opting instead to buy. The impact on paper will be the same, notes Ed Nussbaum, CEO of accounting firm Grant Thornton. Others may look for shorter lease terms, with more options to minimize their debt. Damodaran predicts a “healthy subset” of companies will do whatever they can to keep these leases off the books.

For REITS, putting leases on the balance sheet will have “a huge impact on how we display our financial results,” says AMB’s Olinger. To compensate, he argues, new metrics will be needed to ensure that earnings can be conveyed in a way that investors readily understand.

FASB is aware of such concerns, and chairman Robert Herz acknowledges that more people will have to be consulted before the board determines the presentation of real estate firms’ assets. One proposal would have REITs report both the value of a building’s total lease payments and the residual value of the building after the lease expires. Another would create a different threshold of what defines a capital lease. Some find these solutions worse than the problem, but ultimately transparency is the goal. “Whether you buy or lease, the impact on your balance sheet has to be reflected,” says Tom Jones, vice chairman of the London-based IASB. “Depending on how we move, it may be unpopular.”

Disturbing the Market?

How will the capital markets react to the new, debt-laden balance sheets? “I think there will be a disturbance,” says Bosco. Although a company’s core assets would be no different, investors could be shaken and stock prices might tumble.

Others, however, say that investors already discount the potential effects of leases. Dennis Hernreich, CFO and chief operating officer of Casual Male Retail Group Inc., a men’s clothing chain, predicts that banks, analysts, and ultimately the market will adjust to any change in regulation and account for added liability.

Ratings agencies already do. Moody’s Investors Service, for example, uses a formula factoring a lease’s term and present value to capture what lies beneath the balance sheet. “The analyst community has been sophisticated enough to make adjustments in the past,” says Craig Emrick, an accounting analyst at Moody’s. “[The rule change] might not be as impactful as you’d think.” Debt markets and other financial markets already capitalize leases as part of their analysis, too. “There’s no mystery today,” says Berman.

Perhaps the mysteries of today’s accounting practices have been mostly uncovered. Still, any move to bring hazy accounting principles back to economic reality is likely to come with new and unforeseen wrinkles.

Alan Rappeport is a reporter for CFO.com.

Five Uneasy Lessees
Total operating lease obligations* for five major retailers ($ millions)
Retailer Lease Obligations
CVS $19,875
Home Depot $9,131
Kroger $7,549
Walgreen $26,086
Wal-Mart $10,446
*Amounts do not include certain operating expenses.
Source: Company annual reports